Volatility – Love It Or Leave It

Equity investors have a love-hate relationship with the concept of volatility.

In the “Love” camp: as a matter of practice (if not theory), you need some volatility to see asset price appreciation. Plus, volatility is a sign that markets are connected to the real world of profits and macroeconomics. As sentiment there waxes and wanes, prices should vary and create some (but not excessive) volatility. Lastly, too little volatility means something may be “Wrong” with capital markets. You heard that story a lot last year, for example.

And the “Haters”: unlike the old Mae West line, too much of a good thing isn’t so wonderful when it comes to volatility. Investors know that changes in the CBOE VIX Index are negatively to equity prices. Rising volatility is not, therefore, something long-oriented investors tend to like.

Over the last month we’ve managed to thread this needle: prices are up, and so is expected volatility. Regular readers know we look at the “VIX of” everything from US small caps to Emerging Market equities and industry sectors. This month’s note is that rare occasion when we can report that asset prices are higher despite rising expectations of volatility.

A few points of interest:

The VIX is up from 9.9 to 11.0 since December 22nd, and the S&P 500 is 5% higher as well. Importantly, actual price volatility for the index is no higher than it was a month ago.

The implied volatility in the options chain (the “VIX of”) for Emerging Markets is 35% higher than last month, and the MSCI Emerging Markets Index is 9% in higher in dollar terms over that period.

The same trend holds true US Mid Caps, EAFE Developed Economy equities, precious metals, and high yield corporate bonds.

Now, a piece of this phenomenon of rising prices and “VIX of” these asset classes comes down to seasonality. December is a slow part of the year for both actual price volatility and options trading. As a result, the VIX often troughs in the last month of the year, when compared to other 30 day periods. So while the data we note above is anomalous, in the right context it is also not that surprising.

Where this analysis can help in sector investing is by examining which groups are currently outperforming and then comparing their “VIX” changes.For example:

The large cap Energy sector is finally working well (up 8% over the past month), but its “VIX” rose less than the market average (13% increase vs. 16%) over the period. Verdict: options traders don’t yet feel a need to hedge the move in Energy, implying some confidence the group has further to run.

Financials exhibit the same bullish trends. The group has modestly outperformed over the past month and year-to-date, but options traders have actually reduced the price of the “VIX of” this group by 6% in the past month. We still very much like this group as a sector overweight.

The outlook for large cap Tech is cloudier. While the group has maintained its leadership position, options traders have tacked on 24% to its “VIX” in the last 30 days. Importantly, this increase has come even as actual price volatility is lower over the same period. That’s worrisome – what do they think they know? We still favor large cap Tech, but the options market tells us the next leg of the rally here will be choppier.

If there is one macro warning sign, it comes from the Investment Grade corporate bond market. Returns here have been poor over the last month (down 0.7%) as rates have backed up. But the real warning flares come from the options market, where the “VIX of” this group is 35% higher in the last 30 days – the most of any sector/asset class we track.

We’ve written recently that we only worry about rising US interest rates in the context of the speed of any increase, so the change in the “VIX of” Investment Grade corporate bonds gives us some pause. The increase is far greater than any actual 30-day volatility, so options markets must be concerned of a sudden change long-term interest rates. For the moment, we’re just going to watch this market to see if it reverses course.

And if you are looking for canaries in this current equity market coal mine, this is the one to consider.